Fix and flip investments are an incredibly popular way to make profit in the real estate market, and more and more investors are taking this tried and true tactic to their retirement portfolios. These lend themselves easily to IRA investing, as fix and flip investors are used to coordinating multiple moving parts— the process is new, but the skills and strategy aren’t.
But there are a few rules with self-directed IRAs, and a fix and flip investor who doesn’t keep them in mind can be in serious trouble. So before you get started— make yourself familiar with the 7 mistakes you really don’t want to make with your IRA fix and flip:
1. You can’t buy or sell the property to or from yourself (or a disqualified person)
“[I/my mom/grandfather/son/daughter] already own(s) this property, how do I get it into my IRA?”
The unfortunate answer is, you can’t.
Any transaction with a disqualified person (including yourself) is considered a prohibited transaction by the IRS, which can have major consequences (up to the possible loss of your IRA’s tax-status). You, your mom, or any other lineal ascendants or descendants are considered disqualified persons, meaning your IRA can’t interact with them directly (except in a few specific situations, none of which apply here).
So, if you’re looking buy or sell a property to or from one of those prohibited people, you’ll need to do it outside of the IRA. This applies with a fix and flip just the same as with any other IRA investment— you can’t buy or sell an investment to or from yourself, or any other disqualified person.
2. You can’t hire any disqualified persons to do work on the property
“Can I hire family members to work on my investment?”
No, unfortunately you can’t do this.
If your go-to guy for electrical work is your dad or his company, you’ll have to find someone else for this deal— he can’t work on any properties owned by your IRA. Same goes for having your daughter do any demolition work (even for free!) or hiring your grandfather’s landscaping company to clear brush or plant trees. Disqualified persons can’t do any work on the property, or any transactions with the IRA at all— so no custom ordered tiles sold by your mother’s home decorating business either, even if someone else installs them.
3. You can’t do any work yourself, no matter how small, even if you do it for free
“Can I work do work on the property if I don’t pay myself?”
No, you can’t do that.
You can’t do any work on these properties yourself, no matter how big or small a job— no ripping out floors, no painting trim, no changing locks or watering plants. This is referred to as sweat equity, which the IRS forbids to prevent unfair advantages to IRA investors.
You can manage the property yourself in a hands-off sort of way— you can hire and fire contractors, make management decisions, etc— but you can’t do work on or for the property that would save your IRA money. Even if you don’t pay yourself— or even if you do— you can’t do it.
4. You can’t use the property at all, not even briefly, while it’s in your IRA
“Can I live in my IRA investment property while it's being renovated?”
Unfortunately, you can’t do that.
Before you can use your IRA investments personally, they need to be distributed out of the IRA— so living on-site during or after construction, no weekend vacations, and no day trips, for you OR any disqualified persons. You might think about living in the property while under construction would save some dough— but that’s not allowed in an IRA investment. Keep those sorts of strategies outside of your IRA to keep it compliant.
5. You can’t use ANY personal funds for expenses
“Can I give my IRA a short-term loan to pay these construction costs?”
No, unfortunately that is not allowed.
We know that sometimes unexpected costs come up, but combining of IRA and personal funds is a big no-no— a prohibited transaction that can get your account distributed. All income and expenses must go through the IRA, this is an IRS rule for self-directed accounts.
If you do run low on funds in your IRA, you’ve got a few options. If you haven’t maxed out for the year, you can contribute to your IRA to get additional funding. Or you can move funds to IRAR from another retirement account. If neither of those options are available to you, your IRA can find a partner, get a loan, or sell another asset to get the capital it needs.
6. You can’t personally guarantee any loan (all must be non-recourse)
“Can my IRA get a loan guaranteed by my assets?”
Unfortunately, this is not allowed.
Any personal guarantee of any type for an IRA loan is not allowed, even “bad-boy” carve outs or other terms and conditions tied to your personal financial history. Sometimes your credit may be run, but there can’t be any personal assurance or recourse involved with your loan.
The key is your IRA (not you) is getting this loan, as with all IRA-investments, and only your IRA should come into play. Most banks do not offer non-recourse loans, but some do. This is the only type of loan available to IRA investors. Find more information on lenders who offer non-recourse loans.
7. You can’t forget about UBIT & UDFI
“Do I need to pay UBIT or UDFI for my real estate IRA fix & flip?”
Maybe! It depends.
Unrelated Business Income Tax (UBIT) applies when your IRA engages in activity that is “significantly distinct/unrelated from intended IRA activity”. Certain types of investment income, like income from rental property or proceeds from normal sales, is exempt from UBIT.
However, whether UBIT applies to your fix and flip depends on the structure and frequency of flips.
Some have argued that when an IRA is operating what is effectively a “fix & flip business”, this tax does apply (though “proceeds from normal sales” are listed as specifically exempted). There is no specific number of allowable properties, but typically 4-5 flips a year have been considered “normal activity” and are not generally subject to UBIT (but this is not a hard rule— it’s wise to discuss your specific situation with a tax professional).
If you get a loan (no matter your intentions for the property), your IRA will be subject to Unrelated Debt-Financed Income (UDFI). This comes into play when your IRA earns income on an asset that is debt-financed, where the debt-financed portion of the income is taxed (once you hit $1000).
For example, say you bought a house for $100,000, financing 50% (or $50,000) with a non-recourse loan, and it brings in $500 a month in rental income every month. Each month, 50% of that income is debt financed ($250 a month). Since any income over $1,000 is subject to UDFI, 50% of that fourth rental payment will be subject to UBIT because you financed 50% of the purchase with debt (your loan). Note that, since the amount of debt owed changes with payments made, the percent of the asset considered “debt-financed” is recalculated every year.
Investing in fix and flips with your self-directed IRA is an excellent way to take advantage of your existing team and resources— but to keep your retirement safe, you have a few things to keep in mind. Keep these rules in mind, and you’ll be on the right track to meeting your financial goals for retirement.
Now you know what mistakes to avoid, it’s time to start saving!
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